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Chapter 4

by: Victoria Andreski

Chapter 4 ACCT 4150

Victoria Andreski

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Risk Assessment
Nancy Harp
Class Notes
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This 8 page Class Notes was uploaded by Victoria Andreski on Sunday February 21, 2016. The Class Notes belongs to ACCT 4150 at Clemson University taught by Nancy Harp in Spring 2016. Since its upload, it has received 21 views. For similar materials see Auditing in Accounting at Clemson University.


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Date Created: 02/21/16
CHAPTER 4—Risk Assessment Audit Risk—risk that an auditor expresses an unqualified opinion on materially misstated financial statements • Can control the risk by testing everything, but clients won’t pay for thatàthey must accept audit risk • 2 levels: o Financial statement level § Relates to risk of entire financial statements—qualitatively stated • Always want it “low” or “very low” • Look at each individual assertion o Example: inventory existence (go & physically count) o Individual account balance or class of transactions level • Auditing standards do not provide specific guidance on what is an acceptable level of audit risk • Determination of audit risk involves considerable judgment on the part of the auditor • Auditor CHOOSES (specifies) an ACCEPTABLE (maximum) level of audit risk o You control the audit risk—can get it low by doing a lot of work • Level of Assurance = 1 – Audit Risk o Inverse of audit risk o Example: 5% risk = 95% assurance Audit Risk Model AR = IR x CR x DR • Inherent Risk—susceptibility of an assertion to a material misstatement, assuming there were no related internal controls o Depends on specific assertion being tested o Not considering internal controls o Examples: § Integrity of management—do they do the right thing? § Client motivation § Accounting estimates & complex transactions st § Initial vs. repeat engagement—inherent risk higher for 1 time § Results of prior audits § Other business risks • Control Risk—risk that a material misstatement would not be prevented or detected by the internal controlsà controlled by client o The riskier, the more difficult the audit will be § Want risk to be low o Examples: § Active board of directors/audit committee § Effective internal audit department § Proper computer controls § Proper segregation of duties • Detection Risk—risk that the auditor will not detect a material misstatement in an assertion o Maybe the person trusts the #s on the box of inventory and doesn’t actually open it or just checks the inventory that is the most accessible (don’t check boxes on very top shelves) o Do the wrong test or do the right test in an inappropriate way § Depends on how much work/testing you do & how effective it is o 2 types: § Sampling Risk—may not detect a material problem b/c we aren’t going to count every single piece of inventory—something you simply accept • Reduce by counting more § Nonsampling Risk • Inappropriate audit procedure • Fail to detect when using appropriate audit procedure • Misinterpreting audit results o Assumption: completeness (did everything get recorded?) § Pick the wrong test § Misinterpret audit results • Inherent & Control Risk are INDEPENDENT of the audità can’t control o Risk of material misstatement Engagement Risk—an auditor’s exposure to financial loss & damage to professional reputation • Client & 3 party lawsuits • Negative publicity • Even if we do everything perfect, someone can still come & sue you • Can’t control • Certain industries are riskier • Very carefully screen & choose clients to reduce risk • Always present whether or not audit is in accordance with GAAS • Auditors may gather more evidence than implied by GAAS if there is high engagement risk, but CANNOT gather less evidence than implied by GAAS if there is minimal risk • Cannot be directly controlled by auditor, although some control can be exercised through the client acceptance & continuance process Using the Audit Risk Model 1. Set a planned level of AR such that an opinion can be issued on the financial statements a. Figure out nature, timing, & extent of your audit 2. Assess the risk of material misstatement (IR x CR) 3. Use the AR equation to solve for the appropriate level of detection risk: AR = IR x CR x DR DR = AR   IR x CR • Auditors  use  this  level  of  DR  to  design  audit  procedures  that  will   reduce  AR  to  an  acceptable  level   o When  denominator  gets  big,  result  gets  smallà  that’s  bad   o The  smaller  the  DR,  the  more  work  the  auditor  has  (more   testing)       Case   AR   IR   CR   DR   1   0.05   1.00   1.00   0.05   2   0.05   1.00   0.50   0.10   3   0.01   1.00   1.00   0.01     • Qualitative  terms     Case   AR   RMM   DR   1   Very  low   High   Low   2   Low   Moderate   Moderate   3   Very  low   Low   High     • Can’t  control  RMMà  can  ONLY  assess     Limitations  of  the  AR  Model   • AR  model  is  a  planning  tool,  but  has  some  limitations  that  must  be   considered  when  the  model  is  used  to  revise  an  audit  plan  or  to   evaluate  audit  resultsà  just  a  guide   • Desired  level  of  audit  risk  may  not  actually  be  achieved   • It  does  not  consider  potential  auditor  error   • There  is  no  way  of  knowing  what  the  preliminary  level  of  risk  actually   was       Preliminary Actual or Assessment Achieved Level of Risk + / - Level of Risk     The Auditor’s Risk Assessment Process • Auditors need to identify business risks & understand the potential misstatements that may result • Business Risks—risks that result from significant conditions, events, circumstances, or actions that impair management’s ability to execute strategies • Procedures (How do we gather this evidence?): o Inquiries of management, other entity personnel, & others outside the entity o Talk to client’s executives, key customers, board of directors, lawyers, etc. § Analytical Procedures—relationships that should be there • Ex: interest expense & long-term debt § Observation & Inspection • Look at board minutes, industry reports, & just anything they can • Understanding the Entity & its Environment o Nature of the entity § Entity’s organizational structure & management personnel • The more complex the structure, the more risk § Sources of funding of the entity’s operations & investment activities (capital structure, noncapital funding, & other debt instruments) § Entity’s investments § Entity’s operating characteristics (size & complexity)à major source of risk § Sources of entity’s earnings (relative profitability of key products & services) § Key supplier & customer relationships • A lot of smaller companies rely on just 1 supplier which puts a lot of pressure & risk on them o Industry, regulatory, & external factors § Industry Conditions • Market & competition (demand, capacity, & price) • Cyclical or seasonal activity • Product technology relating to entity’s products • Supply availability & cost § Regulatory Environment • Accounting principles & industry specific practices • Regulatory framework for a regulated industry • Legislation & regulation that significantly affect operations • Taxation • Government policies currently affecting conduct of business • Environmental requirements affecting industry & business § Other external factors • General level of economic activity (recession, growth) • Interest rates & availability of financing • Inflation & currency revaluation o Internal control o Objectives, strategies, & business risks o Entity performance measures     Assessing the Risk of Material Misstatement Due to Error or Fraud • Errors are unintentional misstatements o Human error o Mistakes in gathering/processing financial data used to prepare financial statements o Unreasonable accounting estimates arising from oversight or misinterpretation of facts o Mistakes in the application of accounting principles relating to amount, classification, manner of presentation, or disclosure • Fraud involves intentional misstatements o Fraud risk identification process includes: § Sources of information about possible fraud • Communications among audit team • Inquiries of management & others • Analytical procedures—look at ratios • Unexpected period-end adjustments o Fraud Triangle 3 conditions usually exist when fraud occurs Incentive or pressure Opportunity to carry Attitude or out the fraud (Internal rationalization to to perpetrate fraud Controls) justify fraud • Fraudulent Financial Reporting o Risk factors relating to incentive/pressure include: § Excessive pressure for management to meet 3 party expectations § Financial stability or profitability is threatened § Management’s personal financial situation is threatened o Risk factors relating to opportunities include: § Nature of the industry or entity’s operations § Complex or unstable organizational structure § Ineffective monitoring of management • If you have a lazy board of directors or audit committee is inefficient § Deficient internal control • Segregation of duties are important o Risks factors relating to attitudes/rationalizations: § Nonfinancial management’s excessive participation in selection of accounting principles & estimates § Excess interest by management in stock prices & earning trends § Committing to aggressive or unrealistic forecasts • Get their budgets & forecasts to see how aggressive they are § Ineffective communication of ethical standards or selection of inappropriate ethical standards § Recurring attempts to justify marginal or inappropriate accounting based on materiality • If they say that “No, it’s okay, it’s only small. Quit looking at that.”à red flag § History of violations of securities laws or allegations of fraud • If client has a history of being investigated   Fraud involves intentional misstatements Fraudulent Misappropriation financial of assets (aka reporting stealing)       Fraudulent  financial  reporting  includes:   • Manipulation,  falsification,  or  alteration  of  accounting  records  or  supporting   documents  used  to  prepare  financial  statements   • Misrepresentation  in,  or  intentional  omission  from,  the  financial  statements   of  events,  transactions,  or  significant  information   • Intentional  misapplication  of  accounting  principles  relating  to  amount,   classification,  manner  of  presentation,  or  disclosure       Misappropriation  of  assets:   • Theft  of  an  entity’s  assets  to  the  extent  that  financial  statements  are   misstated   • Examples:   o Stealing  assets   o Paying  for  goods  &  services  not  received  by  the  company   § Could  set  up  a  fake  vendor  that  company  pays  that  is  actually   the  employee  receiving  money  for  fake  services   o Embezzling  cash  received     • Risk  Factors   o Incentives/pressures   o Opportunities   o Attitudes/rationalization       Auditor’s  response  to  the  risk  assessment     • To  respond  appropriately  to  financial  statement  level  risks,  the  auditor  may   do  the  following:     o Emphasize  to  the  audit  team  the  need  to  maintain  professional   skepticism   § When  client  tells  you  something,  be  skepticalà  don’t  just   believe  everything  you  hear   o Assign  more  experienced  staff  or  those  with  specialized  skills   § If  working  w/  client  that  has  more  fraud  risk,  put  more   experienced  worker  on  it  instead  of  an  intern  or  new  staff   o Provide  more  supervision   o Incorporate  additional  elements  of  unpredictability  in  the  selection  of   audit  procedures   § Sometimes  do  a  surprise  count  of  inventory  so  they  can’t  hide   things  or  rearrange  certain  things   § Maybe  ask  lower  level  people  who  don’t  know  to  hide  certain   things     Evaluation  of  Audit  Test  Results   • At  the  completion  of  the  audit,  auditor  should  consider:   1. Whether  the  accumulated  results  of  audit  procedures  affect  the   assessments  of  the  entity’s  business  risk  &  the  risk  of  material   In total, did we do misstatement,  and   enough to 2. Whether  the  total  misstatements  cause  the  financial  statements  to  be   find a materially  misstated   clean THEN….   opinion? • If  the  financial  statements  are  materially  misstated,  the  auditor  should:   1. Request  management  to  eliminate  the  material  misstatement,  or   2. If  management  does  not  make  needed  adjustments,  the  auditor  should   issue  a  qualified  or  adverse  opinion   • If  the  auditor  determines  that  the  misstatement  is  or  may  be  the  result  of   fraud,  &  has  determined  that  the  effect  could  be  material,  the  auditor  should:   o Attempt  to  obtain  audit  evidence  to  determine  whether,  in  fact,   material  fraud  has  occurred  and,  if  so,  its  effect   § Get  a  sense  of  how  big  the  situation  is   o Consider  the  implications  for  other  aspects  of  the  audit   § May  have  to  go  back  into  already  completed  work  to  see  if   there  are  any  connections   o Discuss  the  matter  &  the  approach  to  further  investigation  w/  an   appropriate  level  of  management  that  is  at  least  one  level  above  those   involved  in  committing  the  fraud  &  w/  senior  management   o If  appropriate,  suggest  that  the  client  consult  w/  legal  counsel   o Consider  withdrawing  from  the  engagement     Documentation   • Auditor  should  document:   o Discussions  among  engagement  personnel   o Procedures  performed  to  identify  &  assess  the  risks  of  material   misstatement  due  to  error  or  fraud   o Fraud  risks  or  other  conditions  that  result  in  additional  audit   procedures   o The  nature,  timing,  &  extent  of  procedures  performed  in  response  to   fraud  risks  identified  &  the  results  of  that  work   o Nature  of  the  communications  about  error  or  fraud  made  to   management,  the  audit  committee,  &  others     Communications  about  Fraud   • When  the  auditor  finds  evidence  that  a  fraud  may  exist,  that  matter  should  be   brought  to  the  attention  of  an  appropriate  level  of  management.  Fraud   involving  senior  management  &  fraud  that  causes  a  material  misstatement  if   the  financial  statement  should  be  reported  directly  to  the  audit  committee  of   the  board  of  directors   • Auditor  should  reach  an  understanding  w/  the  audit  committee  regarding   the  expected  nature  &  extent  of  communications  about  misappropriations   perpetrated  by  lower-­‐level  employees   • The  disclosure  of  fraud  to  parties  other  than  the  client’s  senior  management   &  its  audit  committee  ordinarily  is  not  part  of  the  auditor’s  responsibility  &   ordinarily  would  be  precluded  by  the  auditor’s  ethical  &  legal  obligations  of   confidentiality,  EXCEPT  when  the  following  conditions  are  met:   o To  comply  w/  certain  legal  &  regulatory  requirements   o To  a  successor  auditor  when  the  successor  makes  inquiries  of  the   When  you  can   predecessor  auditor  about  the  client   report  to  3   o In  response  to  a  subpoena     parties     o To  a  funding  agency  or  other  specified  agency  in  accordance  w/   requirements  for  the  audits  of  entities  that  receive  governmental   financial  assistance  


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